Since medieval times, jurists have condemned "champerty," the practice of giving money to potential litigants to file and maintain lawsuits in return for a share of the proceeds. But in recent years, opposition to champerty has weakened, opening the door to third-party litigation funding, a burgeoning industry that threatens to increase the volume of litigation and drive up litigation-defense and claim costs. P&C insurers should take careful note of this development.
Third-party litigation funding takes several forms. In the most common example, a funding company provides thousands of dollars to a personal-injury plaintiff and charges interest at annualized rates that can exceed 100 percent of the loan value. These "loans" are generally not subject to state usury laws because they are made on a non-recourse basis: If the plaintiff loses, the funder has no claim for repayment.
Alternatively, the funding company is a specialized investment firm or hedge fund and the borrower a corporate litigant or law firm. Instead of charging interest, the funder receives a predetermined share of any proceeds that result from the lawsuit. In these cases, the funds advanced—which may exceed $15 million—are referred to as "investments" instead of "loans." But regardless of what they are called, third-party funding arrangements turn lawsuits into assets that are partly owned by profit-seeking financiers.
Like all investors, litigation financiers will seek to protect and nurture their investments. A company that gives money to plaintiffs in exchange for a share of the litigation proceeds might pressure its clients to ratchet up settlement demands in order to maximize the funder's profit. For example, if a funder provides $1 million to a plaintiff to pursue litigation in return for 50 percent of any award, the funder will naturally seek to ensure that the plaintiff accepts a settlement offer of no less than $2 million. The $2 million "floor" will be determined not on the basis of the merits of the claim, but on the funder's desire to realize a positive ROI.
Litigation funding's most profound impact may be seen in its eventual shaping of the litigation process and the law itself. While funders insist they make no effort to influence the lawsuits in which they invest, this seems doubtful. The American tort-liability system is continuously shaped by the development of new case law. The malleability of the system makes it susceptible to strategic litigation, where the goal is not simply to prevail in a particular case, but to alter the law by pursuing cases that have the potential to generate favorable precedents.
Well-capitalized litigation financiers would seem to have especially strong incentives to engage in strategic litigation because they stand to benefit significantly from any legal change that would positively affect their portfolio of cases. Hence, they are likely to invest in litigation they believe will lead to certain types of legal change; it is not difficult to imagine situations in which third-party funding is used specifically to develop the "right" set of precedents.
As third-party funding leads to more speculative high-stakes litigation, it is also likely to increase the number of meritless or fraudulent insurance claims that become the subject of litigation.
Imagine an insurer faced with a meritless claim for $200,000 in insured losses. If the insurer calculates that it will cost $20,000 to successfully defend against a potential lawsuit for non-payment of the claim, it makes economic sense to deny the claim. But suppose the insurer calculates it will cost $150,000 to defend against the same lawsuit because of the presence of substantial third-party funding on the plaintiff's side. It will be more cost-effective to settle the claim for $100,000, even though the insurer believes the claim is fraudulent or that coverage is lacking under the terms of the policy.
Insurers already write "nuisance checks" to settle meritless claims in order to avoid the cost of litigation. As third-party litigation funding becomes more prevalent, they will find themselves writing many more such checks—and for much larger amounts.
NAMIC believes sufficient grounds exist for enacting a blanket prohibition against third-party litigation funding. Policymakers who believe the practice can be tamed through regulation should enact stringent measures to limit its negative economic and legal effects.
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